Table of contents

What is Classical Economics?

Decade of 1930s observed remarkable advancement in the study of aggregative economy due to additional pressure of Great Depression which imposed many questions on macroeconomic models of investment, employment and income. Later, John Maynard Keynes developed theory of Employment, Interest and Money which criticized the old orthodoxy termed as ‘classical economics’. Although, initially Classical Economics was considered as scrap by modern Keynesian Economics but later Keynes acknowledged that Classical Economics had an important role in developing macroeconomics.

For Classical economists, at full employment there exists equilibrium level of income, a point where actual output is equal to potential output or aggregate demand is equal to aggregate supply. Equilibrium refers to a condition where all the variables are balanced.

Classical economics primarily examines all the factors that establish full-employment output in line with other related aggregates namely prices, employment, interest rates and wages.

The Classical Revolution

Classical economics was itself developed against an orthodoxy termed as ‘Mercantilism’ which included two systems of belief; bullionism, where prosperity and supremacy of an economy were recognized on the basis of stocks of precious stones and metals and the belief that action of state is needed for development of capitalist system.

Classical economists in opposition to Mercantilism focused on the role of real factors in establishing economy’s actual wealth which pressurized the efficiency of free market rather than government control. Primarily, classical economics analyzed that increase in factors and techniques of production the growth of a nation. Classical economics stressed that money had no intrinsic value; it is only a medium of exchange and has no effect on real variables. Classical economists gave consideration to all the factors that determine overall demand for goods expressed as ‘AGGREGATE DEMAND’. Now, moving onto classical models constructed in detail.

Production

Production Function shows the relationship between physical output of goods and physical inputs used in the process of production, for a given level of technology. It can be expressed as:

N = Quantity of labor inputs (Homogenous)

In short run, capital stock is assumed to be constant, also denoted by a bar and output changes only with the changes in labor inputs.

This is explained with the help of schedule below

N = Labor

Y = Output

∆Y/∆N = MPN

A

0

0

B

1

10

10 Increasing

C

2

22

12 Returns

D

3

28

6 Diminishing

E

4

33

5 Returns

F

5

34

1 Negative

G

6

32

- 2 Returns

N = LABOR

Y = OUTPUT

A

0

0

B

1

10

10 INCREASING

C

2

22

12 RETURNS

D

3

28

6 DIMINISHING

E

4

33

5 RETURNS

F

5

34

1 NEGATIVE

G

6

32

-2 RETURNS

In the above schedule, functional relationship is shown between changes in labor inputs and outputs.

MPN refers to marginal productivity of labor which measures the change in output when an addition unit of labor is employed. Initially when, labor inputs employed are low, production function shows increasing returns and when more and more of inputs are employed diminishing returns set and ultimately negative returns set in and marginal output becomes negative.

In the figure mentioned above, Production function has numerous stages. Initially, when labor input is increased by one, output increases at an increasing rate and then there is another stage when output of additional worker increases total output but marginal output has decreased due to which diminishing returns are said to be set and if labor inputs are kept on being employed then production function would show negative return where total output start diminishing but a firm will not function at this level or labor input employed. Simultaneously, MPN curve (slope of production function) is drawn.

Employment

Classical economists believed that equilibrium level of labor employment is determined by the market forces in labor market and there are no such restrictions for wage adjustment; market clears.

Labor Demand

Basically, firms demand labor services to produce goods and determination of aggregate demand for labor is the summation of demand for labor by all the firms in an economy.

Here, Labor market is assumed to be perfectly competitive and a competitive firm produces an output level where marginal revenues is equal to marginal cost and marginal revenue equals to P(price). Because, labor is assumed to be the only input so marginal cost then becomes marginal labor cost which is equal to the fraction of cost of labor and marginal productivity of labor. For ith firm this relationship can be expressed as:

Therefore, from the above two equation it follows that:A competitive firm will employ labors up to the level where MR = MC or in this case P = W/MPN𝔦

Rearranging this equation we get,

W/P = MPN𝔦The equation implies that labor services will be hired up to the level where additional output produced by employing one more labor (MPN) equals to the real wage (W/P) compensated to that labor. This is also explained with the help of below diagram where MPN curve is a downward sloping curve( diminishing returns) showing inverse relationship between real wage and number of labors employed.

At point B, where real wage is $9 then quantiy of labor demanded is 1 and at point D, where real wage falls to $7, quantity demand of labor is 4 but as quantity of labor increases, real wages fall (because additional output producted by each addtional labor falls as number of labors employed increase). Real compensation tow workers is less than output produced and hence firms can maximize profit by hiring addtitional labor units. Therefore, marginal product of labor curve gives the demand curve for the labor and it is an aggregate demand curve fro all the demand curve of individual firms and this can be express as.

Ns = g (W)/(P) (+)

Work - Leisure Trade Off

Let the money wage be $4, and price be $1 for an hour, and then a worker decides to maximize his utility by working for 9 hours and enjoying 19 hours of leisure as shown in the diagram i.e. he is at point C on his indifference curve. Now, if money wage remains constant and price increase from $1 to $2 then his real wage falls from $4 to $2, as a consequence worker decides to substitute his working hours for more leisure because now leisure has become cheaper and he moves to point B where he chooses to enjoy 16 hours of leisure and work for only 8 hours. Evidently, as real wage increase, leisure decrease and vice – versa which is also significant from the labor supply equation and labor supply curve where as real wage (W/P) increases, labor supply also increases and simultaneously leisure decreases.

Classical Labor Supply Curve gives two Possible Conclusions

First real wage determines labor supply, individual’s utility is eventually derived from the goods and services they can consume and consumption is dependent upon their real wage and hence, they involve in leisure-labor trade off.

Second, Labor Supply curve is positively related with real wage which is also significant from the upward sloping Labor Supply curve. It’s implication lies in the fact that at more real wage worker gives him an incentive to work for more hours and enjoy less leisure hours. In consumer demand, this substitution of leisure by work is referred to as ‘ substitution effect’ but at extremely high level of income, leisure may be more attractive than work due to ‘ income effect’ which would then outweigh ‘substitution effect’ and labor supply curve would bend backward which is why real wage might not be kept at higher level.

Equilibrium Output and Employment

For equilibrium level of Labor Market, we must have Labor Demand and Labor Supply equal.

Production function

Above mentioned condition determines equilibrium in labor market under classical system.In classical economics, variables like output, employment and real wage are termed as Endogenous Variables(Variables that are determined within the classical Model).

Equilibrium in Labor Market is also Explained with the Help of given diagram.

From now on, we take into consideration all the factors that exogenously determine equilibrium in classical model which include all the factors that establish the positions of labor demand and supply curve and aggregate production curve. Production function changes as marginal productivity of labor changes because MPN measure the slope of production function and as labor force varies, labor supply curve shifts.

In classical model, level of output and employment is determined only by supply side factors due to which we move on to see how aggregate labor supply and aggregate labor demand curve determine the level of output with the help of given diagram.

In the above figure, when labor supply and demand curve are drawn against money wage, Ns (P1) gives us the quantity of labor supplied against money wage (W1) when price level is given but worker’s interest lies in real wage so there is a different curve drawn for each price level and when price level doubles, labor supply curve shifts to Ns(2P1 ) implying a fall in employment due to higher price level which matches up with lower real wage.

When money wage and price level changes in equal proportion then labor supply remains constant due to no change in real wage.

When price level changes from P1 to 2P1 and further to 3P1, then labor demand curve shifts to right implying more demand for labor at given money wage because now real wage has fallen down in response to increase in price level and when money wage and price level change in equal proportion then there labor demand remain constant because there is no change in real wage.

It is helpful to derive the classical aggregate supply curve which shows the relationship between total output and aggregate price level. In competitive market, an individual firm produces output which corresponds to labor demand and money wage. On the assumption of keeping money wage fixed, supply curve has a positive slope. When price level rises, real wage falls due to which more labor is demanded and more output is produced.

Classical aggregate supply curve is shown in the below diagram. As, price level changes to 2P>or 3P1,money wage also changes in the same proportion in order to keep real wage constant and hence, output and employment constant as shown in the figure.

Vertical AS curve signifies that higher price levels need to be accompanied by proportional higher money wage in order to keep employment and output constant and hence, in classical model supply determines output.

Factors affecting Output

However, prices have no impact on real variable but stock of capital is an important determinant of real variables such as output, employment and income which is shown with the help of a diagram below.

Here, when technology or stock of capital increases then marginal product of labor increases which shifts the Production Function upward to as shown in the figure and demand for labor also increases and labor demand curve shifts rightward corresponding to an increased level of employment and output, and hence, equilibrium moves from point A to B. When real wage increases from (W/P)1 to (W/P)2 , workers are willing to work for more hours due to which employment moves from N1to N2 and simultaneously there is an increase in output from Y1to Y2 which further shifts the Aggregate Supply Curve from the level YS1 to YS2.